Written by: Steven N. Kurtz, Esq., Partner at Stubbs Alderton & Markiles, LLP
Just when the industry thought I could stop writing about California regulations, along comes California Assembly Bill (“AB”) 2116 which was recently signed into law by Governor Newsome. AB 2116 operates to amend the California Financial Code to address two main issues. First, licensing and rules of the road for all folks who provide commercial financing deals of $500,000 and under. Second, brokers must be licensed and, among other things, need to make certain disclosures including publishing the “average APR for their deals” on the website. This article will focus on commercial financing of $500,000 and under and its implications. Hint, you better get your California finance lender license before 2028 or else.
Non-recourse factoring has always been a confusing issue to the California regulators since the law in all jurisdictions is that a true sale of accounts is not lending. This distinction has traditionally been important when dealing with state usury law and bankruptcy cases. Since a true sale of accounts, where the factor assumes the economic risk of the account debtor’s financial inability to pay is not lending, the factor is not subject to state law usury claims. A true sale of accounts also affords protection in bankruptcy cases because the debtor does not own the accounts since they were sold in a true sale. This means true sale purchased accounts are not property of the bankruptcy estate. Until recently, California regulators did not want to issue licenses to true sale factors and there has been some tension with the California Regulators at the Department of Financial Protection and Innovation (“DFPI”) over this issue. One dirty secret of some of the lawyers in the IFA space is that it’s possible to draft an agreement where the debtor/factor client is in default on day one. This drafting expertise has not caused too many problems in the traditional factoring and ABL worlds. When this drafting expertise makes its way to merchant cash advance agreements, set up as true sales, but where in practice it’s not, this problem can and did make its way to California law makers.
The new set of financing laws apply to covered transactions for a California managed “borrower”, involving any financing of $500,000 or under, to a company which does under $16,000,000 in annual gross revenue. The covered financings include true sale non-recourse factoring agreements and the merchant cash advance loans set up as true sales of “future revenue”. In order to engage in any financial transactions covered by AB 2116, the factor must either have a financial lenders license in place by January 1, 2028, or have the application submitted by that date. If the license is not held or there is no submitted application by the drop-dead date, the financing transaction is unenforceable! This is the first time to my knowledge that any legislative body has deemed a business financing transaction to be unenforceable as a matter of law.
AB 2116 addresses the substance of your financing contracts. The new law prevents confession of judgments before a default. That is a nod to the problem that used to plague borrowers in New York merchant cash advance deals. The procedural mechanisms in California relating to confession of judgments are very strict, so this is not an issue. The new law also prohibits contractual terms which prevent disclosure of financing rates. This is not a problem in my view as it promotes true market competition, but some bad apples had these non-disclosure terms which operated to lock in borrowers and factor clients to their contracts. This issue is also arguably covered by the IFA’s Code of Ethics.
What is also troubling about AB 2116 is that the law prohibits unreasonable provisions in contracts. This is vague. Factoring transactions are inherently risky and require strong language. What may be at risk under the new law will be default related fees that just appear as a fixed fee without any contractual support. Power of attorney clauses may be subject to scrutiny because on paper they look scary. However, power of attorney provisions are common in the financing space and occur in large and small deals. It is unknown how a DPFI regulator will address a power of attorney clause in a small financing deal. It’s an open issue. What is more likely is the state will drill down on when credits are given for collections received and scrutinize contractual support for “float days”
The unenforceability aspect of AB 2116 is a huge problem. The law is set up to protect small businesses in California. In addition to not being enforceable against the factor, there can be other open issues regarding the inability to enforce a non-compliant contract. Can the factor enforce its collection rights against the account debtors. Account debtors may claim to have a good payment defense to enforcement by the factor if the contract the factor relies upon is unenforceable. By law, under UCC Sec. 9-404 account debtors can only claim recoupment and set off as payment defenses. However, UCC 1-103(b) which allows for other legal principals outside the UCC to apply may give some teeth to an account debtor looking to get out of payment because the unenforceable contract which serves as the basis for the account debtor collection may be “fraudulent”. This will be a mess for some trial judge and the unlicensed factor caught in this problem. The failure to be licensed may also open up claims against the factor under unfair competition laws and possibly usury claims since the main safe harbor for California’s strict usury laws, which is the California finance lenders’ license does not exist.
Another area of concern is that a contract may not contain language which operates as a levy or garnishment. Virtually every factoring contract has language which allows for ACH/Wire debits and credits. This operates as de facto control over a bank account, even though actual UCC perfection against funds in a bank account require a deposit account control agreement. While the ability to debit and credit a bank account is integral to a revolving factoring or ABL line and should be enforceable under UCC 9-201, which provides statutory protection for terms in a security agreement, a California Regulator may not agree. Careful attention must be paid to this issue.
It is also unclear whether the new law will creep its way into larger contracts. I do not think there is support for this, but the DFPI regulators are clever and operate without much oversight. License holders are often subject to audits. It’s easy to imagine that the mind set and issues lists for the regulator looking at financing deals in an audit may apply AB 2116 to non-covered transactions. The new law may also result in the DFPI treating small business transactions as consumer deals, which is already happening.
For those with a California finance lenders license, this new law will have some, but not a big impact. You should review your financing contracts for compliance. For those who have been transacting business in California on a non-recourse true sale basis to get around the “California problem”, it means that you will need to obtain the finance lenders license in anticipation of the new law. This may likely result in less scrutiny over past California deals because AB 2116, non-recourse factoring did not technically require a finance lender license. The licensing process can take a while, but for those transacting business in California without a license, it’s best to start the process sooner rather than later.
This new law comes courtesy of the merchant cash advance industry. Unfortunately, factors have been swept into this new law because the state needed to make it clear that it would rope in all covered financing transactions of $500,000 and under involving a business with under $16,000,000 in annual revenues. This is a pretty large net to cast and was done with the intention to require a license in order to operate in the under $500,000 space. There will be a lead time before the effects of the new law go live. While the new law now covers financings which were previously not regulated, the net result is that all non-bank lenders and financing companies will need to obtain the finance lenders license. As for those dealing with brokers, they should be licensed and make sure you address this in your broker agreement.
About the Author
Steven N. Kurtz is a Partner at Stubbs Alderton & Markiles, LLP in the Corporate and Litigation Practices. He is also the Chair of the Commercial Finance, Insolvency, and Specialty Lending Practice. Steven's practice specializes in a range of legal subjects, focusing on bankruptcy and insolvency, business law and transactions, creditors’ rights, commercial law, commercial finance, litigation related to the foregoing, outside general counsel and expert witness/consultant. He assists clients in both transactional matters and litigation. Steve can be reached at skurtz@stubbsalderton.com.
The views expressed in the Commercial Factor website are those of the authors and do not necessarily represent the views of, and should not be attributed to, the International Factoring Association.